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Less Risk For More Reward

OCEAN CITY – Balancing risk against the potential for returns underpins nearly every investment decision. Lately, though, that balance has been difficult to achieve.

The Chicago Board Options Exchange Volatility Index (VIX), which measures expectations of future volatility in the Standard & Poor’s 500-stock index, has reached historic levels over the past few years. It’s not surprising that over two-thirds of high-net-worth investors recently surveyed by Merrill Lynch and the technology consulting firm Capgemini cited "effective risk management" as an "important" or "extremely important" concern.

Many investors seeking protection from volatility and declining markets have fled equities in favor of cash, certificates of deposit (CDs) and money market funds, but returns on these capital-preservation-focused investments have been paltry. Interest on one-year CDs slid to record lows of around 0.54% recently, while one-year T-bills were yielding less than half that. And yields on investment-grade bonds offered by corporate issuers other than financial institutions and banks dropped in late July to less than 4% (3.98%) for the first time on record, according to Merrill Lynch’s High-Grade Non-Financial Index.

"For cash, money market funds or equivalent types of securities, the return is going to stay low for a long time," said Martin Mauro, bond strategist for Merrill Lynch.

Another way to balance risk and reward is to consider investing in vehicles that combine the growth potential of stocks with some of the capital preservation features of bonds in the same neatly packaged instrument.

Market-linked investments, also known as structured investments, are designed to help modulate risk through built-in downside market protection and/or return-enhancement features while adding diversity to your core strategy. In simplest terms, they’re bonds, or debt securities, issued by corporations, including Merrill Lynch’s parent company, Bank of America. Like other corporate bonds, market-linked investments are issued for fixed terms and remain subject to issuer credit risk. But instead of paying you the interest coupons, these bonds provide you with exposure to the performance of another asset or assets, such as a market index, an individual stock, commodities or currencies.

Market-linked investments may be especially attractive to some investors who currently hold exchange-traded funds.

"If you already embrace the index approach to investing — and to building asset allocation around indexes that are transparent and easy to understand — a structured investment may offer value over and above ETFs," says Partridge. "With an ETF, your only choice is to get full upside and downside, but with a market-linked investment you can choose the type of investment structured to fit your current appetite for investment risk."

Of course, there are disadvantages. Although you can sell these securities at any time if you need liquidity prior to maturity, the price of the market-linked investment may be lower than what you might get if you hold the notes to term.

But in a market buffeted by seemingly equal measures of opportunity and uncertainty, such are the trade-offs investors may be happy to make.

"It’s a question of: Does my portfolio need exposure to the underlying asset class? And do I want to take less investment risk when doing so?" says Partridge. If the answers to both those questions are yes, market-linked investments may provide an elusive balance between the two.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)